The Labor Market, Unemployment, and Inflation

CHAPTER
14
The Labor Market, Unemployment, and Inflation
Prepared by: Fernando Quijano and Yvonn Quijano
2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
The Labor Market: Basic Concepts

C H A P T E R 14: The Labor Market, Unemployment, and Inflation
The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force.
Cyclical unemployment is the increase in unemployment that occurs during recessions and depressions.
Karl Case, Ray Fair
2 of 36

Frictional unemployment is the portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.
Karl Case, Ray Fair
3 of 36

Structural unemployment is the portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries.
Karl Case, Ray Fair
4 of 36
The Classical View of the Labor Market

According to classical economists, the quantity of labor demanded and supplied are brought into equilibrium by rising and falling wage rates. There should be no persistent unemployment above the frictional and structural amount.
Karl Case, Ray Fair
5 of 36

The labor supply curve illustrates the amount of labor that households want to supply at each given wage rate.
The labor demand curve illustrates the amount of labor that firms want to employ at each given wage rate.
Karl Case, Ray Fair
6 of 36

Classical economists believe that the labor market always clears.
If labor demand decreases, the equilibrium wage will fall. Anyone who wants a job at W1 will have one. There is always full employment in this sense.
Principles of Economics, 7/e Karl Case, Ray Fair 7 of 36
The Classical Labor Market and the Aggregate Supply Curve

The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical.
When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.
The Unemployment Rate and the Classical View

The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly.
The unemployment rate may sometimes seem high even though the labor market is working well.
Karl Case, Ray Fair
9 of 36
Explaining the Existence of Unemployment

The fact that people are willing to work at a wage higher than the current wage does not mean that the labor market is not working.
The term sticky wages refers to the downward rigidity of wages as an explanation for the existence of unemployment.
Karl Case, Ray Fair
10 of 36

If wages stick at W0 rather than fall to the new equilibrium wage of W* following a shift of demand, the result will be unemployment equal to L 0 L 1.
Karl Case, Ray Fair
11 of 36

One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts. These contracts are unspoken agreements between workers and firms that firms will not cut wages.
Karl Case, Ray Fair
12 of 36

The relative-wage explanation of unemployment holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries.
Karl Case, Ray Fair
13 of 36

Explicit contracts are employment contracts that stipulate workers wages, usually for a period of one to three years. Wages set in this way do not fluctuate with economic conditions.
Karl Case, Ray Fair
14 of 36

Cost of living adjustments (COLAs) are contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.
Karl Case, Ray Fair
15 of 36

The efficiency wage theory is an explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the marketclearing rate.
Karl Case, Ray Fair
16 of 36

If firms have imperfect information, they may simply set wages wrongwages that do not clear the labor market.
Karl Case, Ray Fair
17 of 36

Minimum wage laws set a floor for wage rates, and explain at least a fraction of unemployment.
Karl Case, Ray Fair
18 of 36
The Short-Run Relationship Between the Unemployment Rate and Inflation

In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related.
Karl Case, Ray Fair
19 of 36
The Short-Run Relationship Between the Unemployment Rate and Inflation

As depicted by this short run AS curve, the relationship between Y and the price level (P) is positive.
The relationship between U and P is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more.
The Phillips Curve

The inflation rate is the percentage change in the price level.

The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.
Karl Case, Ray Fair
21 of 36
The Phillips Curve

There is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.
Karl Case, Ray Fair
22 of 36
The Phillips Curve: A Historical Perspective

In the 1960s and early 1970s, inflation appeared to respond in a fairly predictable way to changes in the unemployment rate.
Karl Case, Ray Fair
23 of 36
The Phillips Curve: A Historical Perspective

But in the 1970s and 1980s, the Phillips Curve broke down. The points on this figure show no particular relationship between inflation and unemployment.
Karl Case, Ray Fair
24 of 36
Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve
When AS shifts with no shifts in AD, there is a negative relationship between P and Y. When AD shifts with no shifts in AS, there is a positive relationship between P and Y.
Karl Case, Ray Fair
25 of 36
Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve
If both AD and AS are shifting, there is no systematic relationship between P and Y and thus no systematic relationship between the unemployment rate and the inflation rate.
Karl Case, Ray Fair
26 of 36
The Role of Import Prices

The AS curve shifts when input prices change, and input prices are affected by the price of imports.
There were no large shifts in the AS
curve in the 1960s due to changes in the price of imports.

The price of imports increased
considerably in the 1970s. This led to large shifts in the AS curve during the decade.
The Price of Imports, 1960 I-2003 II

The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 19791980. Since 1981, the price of imports has changed very little.
Expectations and the Phillips Curve

Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation.
Price expectations that affect wage contracts eventually affect prices themselves.
Karl Case, Ray Fair
29 of 36
Expectations and the Phillips Curve

Inflationary expectations shift the Phillips curve to the right.

Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s.
Karl Case, Ray Fair
30 of 36
The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment
When output is pushed above potential GDP (Y0), there is upward pressure on costs. Rising costs push the short-run AS curve to the left. The quantity supplied will end up back at Y0.
If the AS curve is vertical in the long run, so is the Phillips Curve.
The Long-Run AS curve, Potential GDP, and the Natural Rate of Unemployment
In the long run, the Phillips Curve corresponds to the natural rate of unemployment. The natural rate of unemployment (U*) is the unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP.
Karl Case, Ray Fair
32 of 36
The NAIRUThe Nonaccelerating Inflation Rate of Unemployment

Many economists believe the relationship between the change in the inflation rate and the unemployment rate is as depicted by the PP curve in this figure.
Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate).
The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

To the left of the NAIRU the price level is accelerating (positive changes in the inflation rate). To the right of the NAIRU the price level is decelerating (negative changes in the inflation rate).
Karl Case, Ray Fair
34 of 36
The Nonaccelerating Inflation Rate of Unemployment (NAIRU)

A favorable shift of the PP curve is to the left because the PP curve crosses zero at a lower unemployment rate.
A possible recent source of favorable shifts is increased foreign competition, which may have kept both wage costs and other input costs down.
Karl Case, Ray Fair
35 of 36
Review Terms and Concepts

cost-of-living adjustments (COLAs) cyclical unemployment efficiency wage theory
minimum wage laws NAIRU natural rate of unemployment Phillips Curve relative-wage explanation of unemployment social, or implicit, contracts
explicit contracts
frictional unemployment inflation rate
labor demand curve

labor supply curve
sticky wages
structural unemployment unemployment rate

The Labor Market, Unemployment, and Inflation

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The Labor Market, Unemployment, and Inflation

Uploaded by

Copyright:

Available Formats

CHAPTER

Prepared by: Fernando Quijano and Yvonn Quijano

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

The Labor Market: Basic Concepts

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

The Labor Market: Basic Concepts

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

The Labor Market: Basic Concepts

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

The Classical View of the Labor Market

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

The Classical View of the Labor Market

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

The Classical View of the Labor Market

2004 Prentice Hall Business Publishing

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

The Classical Labor Market and the Aggregate Supply Curve

2004 Prentice Hall Business Publishing

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

The Unemployment Rate and the Classical View

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

Explaining the Existence of Unemployment

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

Explaining the Existence of Unemployment

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

Explaining the Existence of Unemployment

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

Explaining the Existence of Unemployment

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 14: The Labor Market, Unemployment, and Inflation

Explaining the Existence of Unemployment

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair